Practice MCQs - Explanations

Q: Which one of the following is a capital budgeting decision? • Determining how many shares of equity to issue • Deciding how to refinance a debt issue that is maturing • Determining how much money should be kept in the checking account • Deciding whether or not to purchase a new machine for the production line Correct answer: Deciding whether or not to purchase a new machine for the production line. Explanation: Capital budgeting is the process of deciding which new project to take on behalf of the company. By project we mean any new decision that requires investment. Deciding whether or not purchase a new machine is a project which if undertaken, will require investment. Q: The original sale of securities by governments and corporations to the general public occurs in the: • secondary market. • private placement market. • proprietary market. • primary market Correct answer: primary market Explanation: We covered this in Lectures 1&2 at the time of discussing ‘Stock Markets’ Q: All of the following were the pre-Big Bang problems at the London Stock Exchange EXCEPT: • increased concentration in jobbing. • fixed brokerage commissions. • restricted membership • dual capacity. Correct answer: Dual capacity Explanation: Dual capacity arrived as a result of the Big Bang (pre-BB it was single capacity) Q: A conflict of interest between the shareholders and management of a firm is called: • shareholders' liability. • corporate breakdown. • corporate activism. • the agency problem. Correct answer: the agency problem Explanation: This is a classical problem in corporate finance. We talked about this when we were discussing the disadvantages of incorporated firms (when we discussed management is separate from owners). 1 Q: Sole proprietorships are predominantly started because: • they are easily and cheaply setup. • all business taxes are paid as individual tax. • there is no requirement to publish accounts • All of the above. Correct answer: All of the above Explanation: We discussed this in Lectures 1&2. Q: Agency costs are incurred by a corporation because: • managers may not attempt to maximize the value of the firm to shareholders. • of a separation of ownership and management. • managers may act as their own interest. • All of the above. Correct answer: All of the above Explanation: All of the above can be an outcome of the agency problems in a firm. Agency problems incur costs. Q: If a market is efficient, then: • there is significant competition among investors. • prices are neither too high nor too low. • all investments are zero NPV investments. • all of these. Correct answer: all of these. Explanation: The first two conditions are the characteristics of an efficient market. The 3rd condition is an outcome of efficient markets. Q: Which one of the following accurately defines a constant perpetuity? • A limited number of equal payments paid in even time increments • Payments of equal amounts that are paid irregularly but indefinitely • Varying amounts that are paid at even intervals forever • Unending equal payments paid at equal time intervals Correct answer: Unending equal payments paid at equal time intervals Explanation: This is how we defined perpetuity in one of our lectures (a normal perpetuity is also referred to as a constant perpetuity) Q: A bond's coupon rate is equal to the annual interest divided by which one of the following? • Call price • Current price • Clean price • Face value Correct answer: Face value 2 Explanation: Coupon rate is the proportion of the face value of a bond that is paid out as coupon (also referred to as annual interest) to the bond holders. Q: An increase in which of the following will increase the current value of an equity according to the constant dividend growth model? I. Dividend amount II. Number of future dividends, provided the current number is less than infinite III. Discount rate IV. Dividend growth rate • I and II only • III and IV only • I, II, and III only • I, II, and IV only Correct answer: I, II, and IV only Explanation: The constant dividend growth model can be written as 𝑃0 = 𝑑1 𝑟−𝑔 The current value of a share (P0) will increase with an increase in all the variables except for the investors required rate of return (r). The generic name for ‘r’ is the discount rate. Q: With an offer for sale contract, the IPO firm: • • • • is unsure of the total amount of funds it will receive until after the offering is completed. knows exactly how many shares will be purchased by the general public during the offer period. retains the financial risk associated with unsold shares. knows up-front the amount of money it will receive from the equity offering. Correct answer: knows up-front the amount of money it will receive from the equity offering Explanation: In an offer for sale contract, the underwriter provides a guarantee that they will buy any of the unsold shares. This way the company that uses this contract knows for sure that all the shares will be sold and hence the amount that will be raised in the IPO. Q: A project has a discounted payback period that is equal to the required payback period. Given this, which of the following statements must be true? I. The project must also be acceptable under the payback rule. 3 II. The project must have a profitability index that is equal to or greater than 1.0. III. The project must have a zero net present value. IV. The project's internal rate of return must equal the required return. • I only • II and III only • I, III, and IV only • I and II only Correct answer: I and II only Explanation: Discounted payback period takes into account the time value of money. If a project’s discounted payback period satisfies the required payback period (also known as the cut-off period) of a company, then it has to be that the payback period also satisfies the cut-off payback period. If the discounted cashflows of a project satisfy the payback period, the profitability index will be at least 1 or greater than 1. Based on the information given about the discounted payback period, we can’t say anything about NPV or IRR. Q: Which one of the following statements is correct? • • • • The lower the volatility of returns, the greater is the required rate of return. The lower the average return, the greater is the required rate of return. The required rate of return is unrelated to the average rate of return. The greater the volatility of returns, the greater is the required rate of return. Correct answer: The greater the volatility of returns, the greater is the required rate of return. Explanation: The higher the risk of an investment (captured by higher volatility of returns) the higher has to be the required rate of return. Q: One year ago, you purchased 500 shares of Best Wings equity at a price of £9.60 a share. The company pays an annual dividend of £0.10 per share. Today, you sold all of your shares for £15.60 a share. What is your total percentage return on this investment? • 38.46 per cent • 39.10 per cent • 39.72 per cent • 63.54 per cent Correct answer: 63.54 per cent Explanation: You can calculate the return on the purchase of a single share or for 500 shares, the return on investment will be the same. Using the formula discussed in Lectures 11 &12 4 Rt = Pt + Ct − Pt −1 Pt + C t  −1 Pt−1 Pt−1 Return = (15.60 + 0.10 - 9.60)/9.60 = 63.54% Q: Ms. Colonial has just taken out a £150,000 mortgage at an interest rate of 6 percent per year. If the mortgage calls for equal monthly payments for 20 years, what is the amount of each payment? (Assume monthly compounding or discounting.) • • • • £1,254.70 £1,625.00 £1,263.06 £1,074.65 Correct answer: £1,074.65 Solution: We can use the PV of an annuity formula. However the PV is given as 150,00 so we need to find the cash flow C. The calculation requires monthly payments so the time period ‘t’ will be 20x12 = 240 C = 150,000/[(1/0.005) - 1/((0.005 × ((1 + 0.005)^240)))] = £1,074.65. We covered this at the time of discussing special cash flows (annuity) Q: A three-year bond with 10 percent coupon rate and £1,000 face value yields 8 percent. Assuming annual coupon payments, calculate the price of the bond. • • • • £857.96 £951.96 £1,000.00 £1,051.54 Correct answer: £1051.54 Solution: PV = (100/1.08) + (100/(1.08^2)) + (1100/(1.08^3)) = £1,051.54. Q: Mr. X invests £1,000 at a 10 percent nominal rate for one year. If the inflation rate is 4 percent, what is the real value of the investment at the end of one year? • • • • £1,100 £1,000 £1,040 £1,058 Correct answer: £1058 Solution: Real investment = (1,000 × 1.10)/(1.04) = £1,058. We discussed this in Lectures 3&4 while covering ‘real vs nominal interest rates’. 5 Q: CK Company stockholders expect to receive a year-end dividend of £5 per share and then immediately sell their shares for £115 dollars per share. If the required rate of return for the stock is 20 percent, what is the current value of the stock? • £132 • £122 • £110 • £100 Correct answer: £100 Explanation: P = (115 + 5)/1.20 = 100. We are using the returns on investment formula. But this time we use the formula to find the purchase price given the return, the selling price and the dividend received Q: Will Co. is expected to pay a dividend of £2 per share at the end of year 1(Div1), and the dividends are expected to grow at a constant rate of 4 percent forever. If the current price of the stock is £20 per share, calculate the investors’ required rate of return. • 10 percent • 4 percent • 20 percent • 14 percent Correct answer: 14 percent Explanation: r = [(Div1/P0 ) + g] = (2/20) + 0.04 = 14%. Q: World-Tour Co. has just now paid a dividend of £2.83 per share (Div0); its dividends are expected to grow at a constant rate of 6 percent per year forever. If the required rate of return on the stock is 16 percent, what is the current value of the stock, after paying the dividend? • • • • £70 £56 £48 £30 Correct answer: £30 Explanation: P0 = (2.83 × 1.06)/(0.16 - 0.06) = 30. Q: Story Company is investing in a giant crane. It is expected to cost £6 million in initial investment, and it is expected to generate an end-of-year after-tax cash flow of £3 million each year for three years. Calculate the NPV at 12 percent. • £2.40 million • £0.80 million • £0.20 million • £1.20 million Correct answer: £1.20 million Explanation: NPV(millions) = -6.0 + 3/1.12 + 3/(1.12^2) + 3/(1.12^3) = 1.2. 6 Q: The real interest rate is 3 percent and the inflation rate is 5 percent. What is the nominal interest rate? • 3.00 percent • 5.00 percent • 2.00 percent • 8.15 percent Correct answer: 8.15 percent Explanation: 1 + nominal rate = (1 + real rate) (1 + inflation rate) = (1.03)(1.05) = (1.0815). Nominal rate = 0.0815 = 8.15%. Q: If the nominal interest rate is 7.5 percent and the inflation rate is 4.0 percent, what is the real interest rate? • 4.0 percent • 9.5 percent • 11.5 percent • 3.4 percent Correct answer: 3.4% Explanation: 1 + real rate = (1 + nominal rate)/(1 + inflation rate) = 1.075/1.04 = 1.0337; real rate = 3.4%. Q: Your firm expects to receive a cash flow in two years of £10,816 in nominal terms. If the real rate of interest is 2 percent and the inflation rate is 4 percent, what is the real cash flow for year 2? • £11,236 • £10,816 • £9,246 • £10,000 Correct answer: £10,000 Explanation: Real cash flow = £10,816/(1.04^2) = £10,000. Q: Stock A has an expected return of 10 percent per year and stock B has an expected return of 20 percent. If 40 percent of a portfolio's funds are invested in stock A and the rest in stock B, what is the expected return on the portfolio of stock A and stock B? • • • • 10 percent 20 percent 14 percent 16 percent Correct answer: 16 percent Explanation: 0.40(10) + 0.60(20) = 16%. 7